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Cheap ARMs Risky, But Offer Buying Leverage

by Broderick Perkins

The 1-Year Adjustable Rate Mortgage (ARM) slipped to a record 3.89 percent last week, the lowest the rate has been since Freddie Mac began tracking them back in 1984, according to Freddie Mac's Primary Mortgage Market Survey ending January 31, 2003.

But before you run out to cash in on the low rates, get to know ARMs and their inherent risks.

And don't overlook 30-year, fixed-rate mortgages (FRMs). At an average 5.9 percent during the same period, FRMs are also at record low levels and they come with a risk-free rate that's fixed for the term of your loan.

Today's ARM note begins as quite a bargain.

Comparing the average 1-year ARM rate with the average FRM rate on a $250,000 loan, you'll spend about $300 less a month on your mortgage payment, during the initial one-year rate period.

But ARMs come with interest rates that typically adjust up, depending upon current economic trends and the money market index to which it is tied.

ARMs are most often based on indexes tied to Treasury Bills that are issued by the U.S. government to pay for the national debt and other expenses. Most 1-Year ARMs are tied to the "Constant Maturity Treasury (CMT)" index which is based on the 1-Year Treasury Bill's activity. Other ARM indexes are based on certificates of deposit (CDs) and the London Inter-Bank Offer Rate (LIBOR) rates, among others.

To come up with the ARM rate, the lender will add a "margin", usually two to four percentage points, to the index.

An ARM's lower initial rate typically is lower than the fixed rate from about a quarter point to two points or more, depending upon the economy. Right now, more than two percentage points separate them.

When the first adjustment occurs (typically from six months to one, three, five, seven and 10 years) and how often the rate adjusts, depends upon the terms of the loan. After the first adjustment occurs, subsequent adjustments typically occur every six months or once a year. The adjustment period is disclosed in the loan.

ARMs also generally have a limit or "cap" on how high it can adjust during each adjustment period as well as how high it can adjust over the life of the loan. The caps protect you from drastic market changes, but ARMS don't offer the stability of a fixed rate loan.

An ARMs' lower initial rate, however, can help you qualify for a larger loan or start you off with smaller payments than you'd have to pay for the same mortgage with a higher fixed rate. Lenders often will qualify you based on the first adjusted rate because it likely will be your average rate paid over the loan's term.

ARMs could be a good choice for someone who knows his or her income will rise and at least keep pace with the loan rate's periodic adjustment. If you plan to move in a few years and are not concerned about the possibility of a higher rate, an ARM also could be a good choice.

The Federal Reserve's "Consumer Handbook on Adjustable Rate Mortgages" poses questions you should consider about ARMs.

And Wayne, PA-based Jack Guttentag, "The Mortgage Professor," offers the Comparing an Adjustable-Rate With a Fixed-Rate Mortgage Calculator to let you compare ARMs with FRMs and calculate your savings.

Get to know your ARM before lifting it to financial-salvation-vehicle status.

Published: February 5, 2003



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